AFM 291 Review notes.docx

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University of Waterloo
Accounting & Financial Management
AFM 291
Robert Ducharme

AFM 291 Review notes Chapter 1 Accounting is defined with three essential characteristics: 1) identification, measurement and communication of financial information about 2) economic entities to 3) interested person Financial accounting: culminates in the preparation of financial reports that cover all of the enterprise’s business activities and that are used by both internal and external parties (investors, creditors) Managerial accounting: the process of identifying, measuring, analyzing and communicating financial information to internal decision makers Most commonly used financial statements are: 1) balance sheet 2) income statement 3) statement of cash flows 4) statement of retained earning Accounting professions measure company performance accurately and fairly on a timely basis and enables investors and creditors to compare the income and assets of companies and thus assess the relative risks and returns of different investment opportunities In Canada, the primary exchange mechanisms for all allocating resources are debt and equity markets and financial institutions An effective process of capital allocation is critical to a healthy economy as it promotes productivity, encourages innovation and provides an efficient and liquid market Stakeholders: parties who have something at risk in the financial reporting environment, includes anyone who prepares, relies on, reviews, audits, or monitors financial information. Stakeholders What is at stake? Investors/ creditors Investment/loan Management Job, bonus, salary increase, access to capital markets by company Securities commissions and stock exchanges Reputation, effective and efficient capital marketplace Analysts and credit rating agencies Reputation, profits Auditors Reputation, profits Standard setters Reputation Others Various Overall objective of financial reporting is to provide financial information that is useful to users and that is decision relevant Management stewardship: whether management is doing their job to maximize shareholder value Management bias: aggressive financial reporting, meet financial analysts’ expectation as it affects a company’s access to capital markets, management’s desire to comply with contracts that the company has, many lending agreements and contracts require certain benchmarks to be met Chapter 2: Conceptual Framework Underlying financial reporting Conceptual framework: coherent system of interrelated objectives and fundamentals that can lead to consistent standards and that prescribes the nature, function, and limits of financial accounting and financial statements The need for conceptual framework: 1) standards setting should build on an established body of concepts and objectives 2) solve new and emerging practical problems. At the first level, the objective identify accounting’s goals and purposes; at the second level are the qualitative characteristics that make accounting information useful; at the third level are the foundational principles used in establishing and applying accounting standards. Relevance and representational faithfulness are fundamental qualities that make accounting information useful. Relevance: capable of making a difference in a decision and has a predictive/feedback/confirmatory value Representational faithfulness: transparency, complete, neutral and free from material error or bias Completeness: includes all information necessary to portray the underlying events and transactions Neutrality: information cannot be selected to favour one set of stakeholders over another Qualitative characteristics include comparability, verifiability, timeliness and understandability Comparability: enables users to identify the real similarities and differences in economic phenomena Verifiability: when knowledgeable, independent users achieve similar results or reach consensus regarding the accounting for a particular transaction Timeliness: information must be available to decision-makers before it loses its ability to influence their decision (quarterly) Materiality: relates to an item’s impact on a firm’s overall financial operations (5% or more of income from continuing operations) Cost vs. benefits: the costs of providing the information must be weighed against the benefits that can be had from using the information Assets have two essential characteristics: they involve present economic resources; the entity has a right or access to these resources where others do not Economic resources: things that are scarce and capable of producing cash flows where the right to access is an enforceable right Liability: they represent an economic burden or obligation, the entity has a present obligation Constructive obligations: arise through past or present practice that signals that the company acknowledges a potential economic burden Comprehensive income: includes net income and all other changes in equity except for owners’ investments and distributions: unrealized holding gains and losses on certain securities, certain gains and losses related to foreign exchange instruments, gains and losses related to certain types of hedges Foundational principles: explain which, when and how financial elements and events should be recognized, measured and presented/disclosed 10 foundational principles: recognition (economic entity, control, revenue recognition and realization, matching), measurement (periodicity, monetary unit, going concern, historical cost, fair value), and presentation and disclosure (full disclosure) Revenue recognized when: 1) risks and rewards have passed or the earnings process is substantially complete 2) measurability is reasonably certain 3) collectability is reasonably assured Historical cost principle: 1) represents a value at a point in time 2) it results from a reciprocal exchange 3) the exchange includes an outside party Chapter 3: The Accounting Information System Basic terminology includes: event, transaction, account, permanent and temporary accounts, ledger, journal, posting, trial balance, adjusting entries, financial statements, closing entries The accounting cycle 1. Identification and measurement of transactions and other events 2. Journalization: general journal 3. Posting: general ledger (usually monthly), subsidiary ledger (usually daily) 4. Trial balance preparation 5. Adjustments: accruals, prepayments, estimated items 6. Adjusted trial balance 7. Statement preparation: income statement, retained earnings, balance sheets, cash flows 8. Closing (temporary accounts) 9. Post-closing trial balance 10. Reversing entries Posting: transferring items in a general journal to the general ledger Example: Nov. 11/ buys a new delivery truck on account from Auto Sales Inc. $22,400 General journal page 12 Date 2010 Account title and explanation Ref. Debit Credit Nov. 11 Delivery Equipment 8 22,400 Accounts Payable 34 22,400 Posting Delivery Equipment No. 8 Accounts Payable No. 34 Nov. 11 GJ 12 22,400 Nov. 11 GJ 12 22,400 Trial Balance The procedures for preparing a trial balance consist of: 1) listing the account title and their balances 2) totalling the debit and credit columns 3) Proving the equality A trial balance does not prove that all transactions have been recorded or that the ledger is correct. Adjustments are needed to ensure that the revenue recognition principle is followed and that proper matching occurs Types of adjusting entries Prepayments Accruals 1. Prepaid expenses: expenses paid in cash and recorded as 1. Accrued revenues: revenues earned but not yet received assets before they are used or consumed in cash or recorded 2. Unearned revenue: revenues received in cash and 2. Accrued Expenses: Expenses incurred but not yet paid in recorded as liabilities before they are earned cash or recorded Prepaid expenses expire either with the passage of time or by being used and consumed. If no adjustment entries are made, assets are overstated and expenses are understated. Book value and market value are generally two different things. Accrual revenue recorded as accounts receivable and not unearned revenue Bad debts: In order to properly match revenues with expenses, a bad debt must be recorded as an expense of the period in which the revenue was earned instead of being recorded in the period when the accounts or notes are written off. Closing process: the procedure that reduces the balance of temporary accounts to zero in order to prepare the accounts for the next period’s transaction, all transfers to income summary, only at year end, then close income summary to retained earnings With a perpetual inventory system, purchases and sales are recorded directly in the inventory account as they occur; therefore balance in inventory should reflect the ending inventory account. A cost of goods sold is used to accumulate what is issued from inventory. With a periodic system, a purchase account is used and the inventory account is unchanged during the period to reflect the beginning inventory. At the end of the period, the inventory account is adjusted by closing out the beginning inventory amount and recording the ending inventory amount. Cost of goods sold is determined by adding the beginning inventory to net purchase and deducting the ending inventory 3A: reversing entries: Example: accruals 1. October 24 (initial salary entry): $4000 of salaries expense incurred between October 1 and October 24 is paid 2. October 31 (adjusting entry): $1200 of salaries expense is incurred between October 25 and October 31. This will be paid in the November payroll 3. November 8 (subsequent salary entry): $2500 of salaries expense is paid. Of this amount, $1200 applies to accrued salaries payable at October 31 and $1300 was incurred between November 1 and November 8. Reversing entries not used Reversing entries used Initial salary entry Oct. 24 Salaries Expense 4,000 Oct. 24 Salaries Expense 4,000 Cash 4,000 Cash 4,000 Adjust entry Oct. 31 Salaries Expense 1,200 Oct. 31 Salaries Expense 1,200 Salaries Payable 1,200 Salaries Payable 1,200 Closing entry Oct. 31 Income Summary 5,200 Oct. 31 Income Summary 5,200 Salaries Expense 5,200 Salaries Expense 5,200 Reversing entry Nov. 1 Salaries Payable 1,200 Nov. 1 No entry is made Salaries Expense 1,200 Subsequent salary entry Nov. 8 Salaries Expense 2,500 Nov. 8 Salaries Payable 1,200 Cash 2,500 Salaries Expense 1,300 Cash 2,500 Example: prepayments 1. December 10 (initial entry): $20,000 of office supplies is purchased for cash 2. December 31 (adjusting entry): $5,000 of office supplies is on hand Reversing entries not used Reversing entries used Initial purchase of supplies entry Dec. 10 Office Supplies Expense 20,000 Dec. 10 Office Supplies 20,000 Cash 20,000 Cash 20,000 Adjust entry Dec. 31 Office Supplies 5,000 Dec. 31 Office Supplies Expense 15,000 Office Supplies Expense 5,000 Office supplies 15,000 Closing entry: Dec. 31 Income Summary 15,000 Dec. 31 Income summary 15,000 Office Supplies Expense 15,000 Office Supplies Expense 15,000 Reversing Entry Jan 1. Office Supplies Expense 5,000 Jan.1 No entry Office Supplies 5,000 Chapter 7: cash and receivables Financial asset is any asset that is: 1) Cash 2) A contractual right to receive cash or another financial asset from another party 3) A contractual right to exchange financial instruments with another party under conditions that are potentially favourable to the entity or 4) An equity instrument of another entity Cash: the most liquid asset, standard of medium of exchange and the basis for measuring and accounting for all other items Cash includes: - Coins, currency, and other available funds deposited at the bank - Money orders, certified cheques, cashier’s cheques, personal cheques and bank drafts - Petty cash funds and change funds Cash equivalent (short-term investment): money-market funds, certificates of deposits (CDs) Restricted cash: separately disclosed and reported in the current assets section or is classified separately in the long-term assets section ` - Compensating balance: portion of any demand deposit that a corporation keeps as support for its existing or maturing obligations with a lending institution Cash in foreign currencies: if there is no restriction on the transfer of those funds to the Canadian company, categorized as cash, otherwise, it is reported as restricted Bank overdraft: when cheques are written for more than the amount in the cash account Cash equivalents: short-term, highly liquid investments that are readily convertible to known amounts of cash and subject to an insignificant risk of change in value. Usually investments with original maturities of three months or less qualify Receivable: - Loans and receivables: one party delivering cash to a borrower in exchange for a promise to repay the amount on a specified date or dates - Trade receivables: amounts owed by customers to whom the company has sold goods or services as part of its normal business - Open accounts receivable: based on a purchaser’s oral promise - Notes receivable: written promise to pay a certain amount - Nontrade receivable: does not arise from daily operation of the company, can be written promise either to pay cash or to deliver other assets, usually reported as separate item on balance sheet Trade discount: to quote different prices for different quantities purchased Cash discounts (sales discounts): encourage fast payment, 2/10, n/30 Gross method vs. net method Gross method Net method Sales of $10,000, term 2/10, n/30 Accounts Receivable 9,800 Accounts Receivable 10,000 Sales 9,800 Sales 10,000 Payment on $4,000 of sales received within discount period Cash 3,920 Cash 3,920 Accounts Receivable 3,920 Sales Discount 80 Accounts Receivable 4,000 Payment on $6,000 of sales received after discount period: Accounts Receivable 120 Cash 6,000 Sales Discounts Forfeited 120 Accounts Receivable 6,000 Cash 6,000 Accounts Receivable 6,000 Sales returns and allowance Sales Returns and Allowance (contra revenue account) 50,000 Allowance for Sales Returns and Allowance (contra asset account) 50,000 Interest element is generally not recognized with accounts receivable because it is usually not material compared with the net income of the period One common method used to estimate how much of total accounts receivable is probably uncollectible is the aging method. Percentage-of-receivables approach Accounts Receivable Aging Schedule Name of customer Balance Dec. 31 Under 60 days 61 – 90 days 90 – 120 days Over 120 days Western Stainless Steel Cor. 98,000 80,000 18,000 Brockville Steel Company 320,000 320,000 Freeport Sheet & Tube Co. 55,000 55,000 Manitoba Iron Works Ltd. 74,000 60,000 14,000 547,000 460,000 18,000 14,000 55,000 Age Amount Percentage estimated to be uncollectible Estimate of uncollectible accounts Under 60 days old 460,000 4% 18,400 61 – 90 days old 18,000 15% 2,700 91 – 120 days old 14,000 20% 2,800 Over 120 days 55,000 25% 13,755 37,650 Therefore, the balance sheet of Wilson & Co would look like this: Current asset Accounts Receivable $547,000 Less: Allowance for doubtful accounts 37,650 $509,350 The entry to record the bad debt would be: Bad Debt expense 37,650 Allowance for Doubtful Accounts 37,650 If the allowance account already has a credit balance of $800 before adjustment, then the entry would look like this: Bad debt expense 36,850 (37,650 – 800) Allowance for Doubtful Accounts 36, 850 Accounts written off and the allowance account - When a specific account is determined to be uncollectible, its balance is removed from accounts receivable and the allowance for doubtful account is reduced. Assume $550 from Brown Ltd. is uncollectible: Allowance for doubtful accounts 550 Accounts Receivable 550 Collection of an accounts previously written-off Accounts receivable 550 Allowance for doubtful Accounts 550 Cash 550 Accounts Receivable 550 For some cash-based businesses, they have every few credit transactions and preferably use the simpler direct write-off method: Bad debt expense $$ Accounts Receivable $$ To recover an amount previously written off: Cash $$ Uncollectible amounts recovered $$ Interest-bearing note: have a stated rate of interest that is payable in addition to the face value of the note Zero-interest-bearing note: includes interest but it is equal to the difference between the amount borrowed and the higher face amount that will be paid back Example: On March 14, Prime Corporation agrees to lend Gouneau Ltd. 1000 for 6 months at 6%. The entry is: March 14 Note Receivable 1000 Accounts Receivable 1000 Sept 14 Cash 1030 Note Receivable 1030 Interest Income 30 (1000 x 0.6 x 6/12) The president of Ajar Ltd. borrowed money from the company on Feb 23 promising to pay back 5000 in 9 months with an interest rate of 8%. Instead of receiving 5000, the president receives 4717 (4717 x 8% x 9/12 = 283) Feb 23 Note Receivable 4717 Cash 4717 November 23 Cash 5000 Notes Receivable 4717 Interest income 283 Effective interest method of amortization vs. straight-line method Cash received Interest income Discount amortized Carrying amount of note Date of issue 0 7721.8 End of year 1 0 694.96 694.96 8416.76 End of year 2 0 751.51 757.51 9174.27 End of year 3 0 825.73 825.73 10,000.00 0 2278.20 2278.20 Oasis Corp. sold land in exchange for a five-year note that has a maturity value of $35,247 and no stated interest rate. The property originally cost Oasis $14,000. What are the proceeds on disposal of the land? Situation 1: Assume the market rate of interest is 12%. Present value of 35,247 is 20,000 (35,247 x 0.56743) Notes Receivable 20,000 Land 14,000 Gain on Sale of Land (20,000 – 14,000) 6,000 Situation 2: the market rate of interest is unknown, however the land has been recently appraised for $20,000. Therefore, 20,000 / 35247 = 0.56742. Compare this with the table; it is found the market interest rate is 12% Sometimes, the cash that is exchanged when the loan is made may not be the same as the fair value of the loan. For example, a company advances $20,000 to an officer of the company, charges no interest on the advance and makes it payable in four years. Assume a market rate of 6%. ($20,000 x 0.79209 = 15842) Although the loan’s fair value is only 15,842, the officer actually receives $20,000. The journal entry is: Note/loan receivable 15,842 Compensation Expense 4,158 Cash 20,000 Asset-backed financing: receivables can be used to generate immediate cash for a company in two ways: 1) secured borrowings 2) sales of receivables Receivable sold without recourse: the purchaser assumes the risk of collection and absorbs any credit losses. Example: Crest Textiles Ltd. factors $500,000 of accounts receivable with Commercial Factors, Inc. on a without recourse basis. Commercial Factors assess a finance charge of 3% of the amount of accounts receivable and withholds an initial amount equal to 5% of the accounts receivable. Crest Textiles Ltd. Commercial Factors, Inc Cash 460,000 Accounts Receivable 500,000 Due from Factor (5% x 500,000) 25,000 Due to Crest Textiles 25,000 Loss on Sale of Receivables (3% ) 15,000 Financing Revenue 15,000 Accounts Receivable 500,000 Cash 460,000 Receivable sold with recourse: the seller or transferor guarantees payment to the purchaser if the customer fails to pay Example: Same as above but Crest Textiles estimates that the recourse obligation has a fair value of $6,000. Net proceeds are cash or other assets received in a sale less any liabilities incurred. Calculation of net proceeds: Cash received $460,000 Due from Factor 25,000 485,000 Less: Recourse obligation 6,000 Net proceeds 479,000 Calculation of loss on sale: Carrying amount of receivables $500,000 Net proceeds 479,000 Loss on sale of receivables 21,000 Below are the journal entries: Crest Textiles Ltd. Commercial Factors, Inc. Cash 460,000 Accounts Receivable 500,000 Due from Factor 25,000 Due to Crest Textiles 25,000 Loss on Sale of Receivables Account 21,000 Financing Revenue 15,000 Receivable 500,000 Cash 460,000 Recourse Liability 6,000 To assess the receivables’ liquidity, the receivables turnover ratio, a ratio that measures the number of times, on average, that receivables are collected during the period Accounts receivable turnover = (net sales/revenue)/average trade receivables Management must overcome two problems in accounting for cash transactions: 1) it must establish proper controls to ensure that no unauthorized transactions are entered into by officers 2) it must ensure that the information that is needed in order to properly manage cash on hand and cash transactions is made available. Bank reconciliation Balance per bank statement xxx Balance per company’s book xxx Add: Deposits in transit xxx Add: Bank credits and collections not yet recorded in book Undeposited receipts xxx xxx Bank errors that overstate the bank statementxxx xxx Book errors that understate the book balance xxx xxx xxx Deduct: Outstanding cheques xxx Bank errors that understate the BS xxx xxx xxx Correct cash balance xxx Deduct: Bank charges not yet recorded in the books xxx Book errors that overstate the book balance xxx xxx Correct Cash balance xxx Chapter 8: Inventory Inventories are defined as “assets” that 1) held for sale in the ordinary course of business 2) in the process of production for such sale or 3) in the form of materials or supplies to be consumed in the production process or in the rendering of services Inventory categories: 1) merchandise inventory 2) raw materials inventory 3) work-in-process inventory 4) finished goods inventory Recognition and measurement Goods in transit: F.O.B (free on board), risks and rewards of ownership are transferred to buyer once seller delivered the goods to the common carrier, meaning buyers have to include those as ending inventories. If they don’t do so, inventories and accounts payable on balance sheet are understated and purchases and ending inventories on income statement are understated as well. - Accountants usually prepare a cut-off schedule to ensure that goods received from suppliers around the end of the year are recorded in the appropriate period Special sales agreements: sometimes, it is possible for legal title to pass to the purchaser but for the seller of the goods to still retain the risks of ownership. - Sales with buyback agreement (product financing arrangement): seller “parks” the inventory on another company’s balance sheet for a short period of time, agreeing to repurchase it in the future. - Sales with high rates of return: if a reasonable prediction of the returns can be established, then the goods should be considered sold and an allowance for returns should be recognized. However, if returns are unpredictable, the sale is not recognized and the goods are not removed from the inventory account (e.g. publishing books, music, sporting goods that allow full or partial refund) - Sales with delayed payment terms: sale is recorded and the goods are removed from the seller’s inventory if the cost of the outstanding risk can be reasonably estimated and matched with the related revenue. Both IFRS and private entity GAAP indicate that inventory cost is made up of all costs of purchase, costs of conversion (transportation), and other costs incurred in bringing the inventories to their present location and condition. Purchase discounts: gross method vs. net method Gross method: both the purchase and payables are recorded at the gross amount of the invoice, any purchase discounts that are later taken are credited to a purchase discount account. Net method: records the purchases and accounts payable initially at an amount net of the cash discounts. Gross method Net method Purchase cost of $10,000, terms 2/10, net 30: Purchases 9800 Purchase 10,000 Accounts Payable 9800 Accounts Payable 10,000 Invoices of $4000 are paid within discount period Accounts Payable 3920 Accounts Payable 4000 Cash 3920 Purchase discount 80 Cash 3920 Invoice of $6000 are paid after discount period: Accounts Payable 5880 Accounts Payable 6000 Purchase discounts lost 120 Cash 6000 Cash 6000 Vendor rebates Rebates receivable 6000 Inventory (5000 units) 500 Cost of Goods sold (55,000 units) 5500 Product costs: costs that “attach” to inventory and are recorded in the inventory account. These costs are directly connected with bringing goods to the buyer’s place of business and converting them to a saleable condition. (E.g. transportation, labour costs to set up the products ready for sale) “Basket” purchases and joint product costs Example, a company purchased a land for $ 1 million dollars with 400 lots. It is inappropriate to calculate the value of each lot as $2500. Instead, it is more reasonable to allocate the total cost among the various units based on their relative sales value. Lots Number of Sales price per Total sales Relative sales Total cost Cost allocated Cost per lot lots lot value value to lots A 100 10,000 1,000,000 100/250 1,000,000 400,000 4,000 B 100 6,000 600,000 60/250 1,000,000 240,000 2,400 C 200 4,500 900,000 90/250 1,000,000 360,000 1,800
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